Defence Industry - UK - November 2015
Executive Summary
 
“The government’s commitment to spend the NATO-recommended 2% of GDP on the defence sector until 2020 has allowed the industry to plan its operations going forward. However, the western world’s growing tension with Russia, the global threat of terrorism, and emerging cyber security dangers provide a reminder of the changeable nature of conflict and that all those involved in operations must remain vigilant, flexible, and prepared to enter conflicts when required.”
-Lewis Cone, B2B Analyst

Market size
Departmental expenditure limits in the defence sector reached £42.9 billion in 2014/15, representing close to a £1.2 billion decrease over the previous year and a decline of £5.4 billion compared to the pre-SDSR level in 2010/11. The annual rate of change in DEL has fluctuated between -7% and 10% since 2009/10, and can be largely attributed to the expenditure cuts implemented from 2011 onwards.

FIGURE 1: UK Defence Departmental Expenditure Limits and Defence Spending, 2010/11-2014/15
 
(£ million)
 
Source: MBD analysis of Public Expenditure Statistical Analyses 2015

Between 2012/13 and 2015/16, the Ministry of Defence spent an increasing amount on military equipment after the £1.4 billion fall in spending in 2011/12. Equipment expenditure rose by 11% from £13.9 billion in 2012/13 to £15.4 billion in 2014/15, with a further £189 million increase expected in 2015/16. By 2014/15, only equipment support spending was at a higher level than the start of the review period in 2011/12, at £6.4 billion compared to £6.3 billion.

FIGURE 2: MoD Equipment Expenditure, 2011/12-2015/16
 
(£ Million)
 
Source: MBD analysis of UK Defence Statistics & Defence Economics data and estimates

Market trends
In 2014/15, 41.5% of total MOD procurement expenditure was with 10 suppliers. The largest was BAE Systems, which has been the case in previous years. Nine private sector organisations were paid more than £500 million (VAT exclusive) by the MoD, including Airbus Group NV, Babcock International Group PLC, BAE Systems PLC, and Finmeccanica SpA. The underlying trend suggests that major suppliers to MoD are declining as a proportion of their global revenues, reflecting the consolidation and internationalisation of the global defence industry and the relative decline in MoD spending compared to global defence spending.

Since the financial crisis and subsequent defence spending cuts in parts of the western world, there has been a reduction in military holdings in the UK, Germany, Cyprus, and Gibraltar as classified within the scope of the Conventional Armed Forces in Europe Treaty. When comparing units held by nations in 2011 to 2015, only the number of artillery holdings and armoured vehicles has increased.

FIGURE 3: Military Holdings in the UK, Germany, Cyprus and Gibraltar within the scope of the Conventional Armed Forces in Europe Treaty, by Equipment Group, 2010 and 2014
 
(Number)
 
Source: MBD analysis of MoD Data

The US is the single largest investor in military expenditure, accounting for a significant 43% of total world military expenditure in 2010 and 36% in 2014. Much of the US’ military spending was for costs incurred in Afghanistan and Iraq. However, China may start to rival the US as it accounted for 13% of total military expenditure in 2014 - up by 5% from only four years earlier. France, the UK, Japan, Germany, Italy, and Canada all experienced declines in their respective global position over the review period, whereas the UAE, India, South Korea, Saudi Arabia, and Russia all improved their positions in military spending.

FIGURE 4: Defence Spending 2010 and 2014, World’s Top Six
 
(% World Share in $ Billion at current prices and converted at the exchange rate for the given year)
  
Source: MBD analysis of SIPRI data

According to NATO’s June 2015 defence expenditure data report, spending in the alliance is estimated to have fallen by US$121 billion since 2010, while Russia more than doubled its defence budget between 2008 and 2014. Moreover, IHS estimates that NATO will fail to account for the majority of worldwide defence expenditure for the first time in its history by 2019 - having accounted for almost two-thirds of global spending in 2010.

Market factors
Current conflicts dictate spending patterns
The repercussions of the Ukraine crisis and the emergence of IS will continue to cause a flux in prevailing defence spending trends. Events in Ukraine have already shown signs of reversing recent negative defence budget trends in some Eastern European countries and have impacted Russian spending plans. Meanwhile, the open-ended timetable for the campaign against the self-titled ‘Islamic State’ will postpone planned declines in operational spending in the Western world and create an impetus behind security concerns in the Middle East and beyond. The future development of these crises is likely to have a significant impact upon funding considerations over the short term at least.

R&D funding affecting response time and ability to compete as a global equipment buyer
The UK’s R&D budget has more than halved since 2001 and is now less than £2 billion of the MoD’s overall budget. The low level of investment into developing new equipment and programmes could lead to national security being compromised by technologically advanced opponents. Research and development investment supports export growth and helps maintain the UK’s operational relevance to allies and its ability to compete as an intelligent buyer on the global market. The UK DSC and the Security Innovation and Demonstration Centre provide models for bringing the defence and security sectors into the process at the outset to collaboratively support the definition of solutions to meet the requirements of domestic and overseas customers. It is hoped that this will help preserve the UK’s global position over the forthcoming years.

Shift in global spending levels and exports
The IHS forecasts that the move in global defence spending away from the developed economies of Western Europe and North America towards emerging markets, such as Asia, will be complete by 2020. In terms of overall regional growth between 2015 and 2020, the Asia-Pacific is expected to cement its role as the key driver of growth in the defence sector. China’s defence spending alone is estimated to grow by 7% annually over the next five years to a projected $260 billion in 2020 - almost double its 2010 spending of $134 billion. The rise in Chinese spending comes as global defence expenditure stagnates, not least because of the fiscal constraints among oil-producing countries in the Middle East and North Africa. US spending has also been curtailed by the reduction in troops on the ground in Afghanistan and ongoing budget cuts.

Monopolistic market for complex weapons restricts other entrants to the sector
The market for complex weapon systems, such as warships and fighter aircraft, is monopsonistic as the market only has one national customer - the MoD. As a result, the MoD’s buying decisions set demand in the UK market and determine the structure of the defence industry and the type of products it produces. In many sectors, the MoD faces monopoly suppliers as companies cater to MoD demands. This means there is little space or profitability for other entrants.

The next Strategic Defence and Security Review is likely to lead to a further push towards efficiency
The SDSR 2015 is currently being formed by the Cabinet Office, Department for International Development, Foreign and Commonwealth Office, Home Office, Ministry of Defence, and other departments, and is expected to be announced in November 2015. A key principle of the next SDSR is likely to focus on improving the efficiency and effectiveness of all aspects of the generation, deployment and use of national defence and security capability. In the current climate of restricted levels of public resources, getting more out of existing capability is likely to be a key aim. The UK defence industrial base already plays a crucial role in generating and sustaining specific areas of capability. The review provides an opportunity to examine ways of extending that role to the benefit of the Armed Forces, security services, the taxpayer, and industry.

Companies
The industry is inevitably driven by government spending, which in turn is characterised by large contract sizes, and a protracted and often highly bureaucratic specification chain. The value of individual contracts is such that the purchaser commands considerable bargaining power. However, the defence industry is also dominated by a relatively small number of extremely large companies, which also command some power. There are inevitable security implications and only the larger companies are able to cope with the protracted nature and inherent uncertainty of such large-scale contracts.

Defence companies believe they are in the best position to lead the development of the cyber security market as they already have the security clearance to handle the most sensitive government projects - as demonstrated by Lockheed Martin’s status as the US government’s largest cyber security provider. Extending this provision to the wider civilian market, including banks and utilities, has proven to be a tougher challenge.

Growth markets, such as China and Russia, are mainly captive markets, with most business directed towards domestic players. The few accessible international markets for the UK, such as Saudi Arabia, India and Brazil, are therefore increasingly competitive. As a result, the UK government and its European trading partners are negotiating ways to make changes to their defence structures, and to downsize and reshape their respective industrial bases at an appropriate pace.

The exposure of the sector to the MoD defence budget will put major pressure on the industry over the next few years, with the defence procurement reforms implemented by the previous coalition government. The MoD spends about 40% of its entire budget on equipment and support, and has laid out plans to spend £163 billion on equipment and support between 2014 and 2024.

The US-based companies, Lockheed Martin and Boeing, are the two largest defence companies in the world, followed by the UK-based company, BAE Systems. The US is home to six of the 10 largest defence companies in the world, which correlates with the country having the world’s largest defence budget. Meanwhile, the UK is home to 10 of the largest 100 defence companies in the world, with more than 20 others having significant operations in the region.

Forecast
Defence DEL set to rise over the next three years while total DEL is anticipated to fall
Despite the anticipated declines in departmental expenditure limits over the next three years, defence DEL is expected to increase over each year until 2017/18. In 2015/16, current defence DEL plans suggest that spending will account for 9.8% of total DEL. After the government’s summer budget in July 2015 and its pledge to meet NATO’s target of 2% of GDP on the defence sector until 2020, defence DEL’s share of total DEL is expected to rise by 0.6% annually to 11% in 2017/18. Total DEL is anticipated to fall over the next three financial years by a total of £23.4 billion to £333.3 billion in 2017/18 as the government continues its austerity measures.

FIGURE 5: Forecast UK DEL on Defence, 2015/16-2017/18
 
(£ Billion)
 
Source: MBD analysis of HM Treasury data and forecasts

The next SDSR, due in November, is expected to continue to streamline full-time force numbers and military holdings to improve efficiency
A key principle of the next SDSR is likely to be improving the efficiency and effectiveness of all aspects of the generation, deployment, and use of national defence and security capability. In the current climate of restricted levels of public resources, getting more out of existing capability is likely to be a key aim. The UK defence industrial base already plays a crucial role in generating and sustaining specific areas of capability. The review provides an opportunity to examine ways of extending that role to the benefit of the Armed Forces, security services, the taxpayer, and industry. The review could also address the skills gaps in areas such as defence engineering and cyber security. Clear articulation of requirements and technology ‘road maps’ help industry forecast demand, while the SDSR could provide an opportunity to explore what additional steps government and industry can take to retain advanced engineering capability in the UK.

The directional change in global defence spending patterns and exports poses challenges to the UK’s position as the second largest defence equipment exporter in the world
The rise in the proportionate share of global defence spending in emerging markets, especially those in Asia and the Middle East, means that the UK must adapt its current trading and manufacturing deals to maintain its position within the industry. However, the UK government has been criticised for sanctioning arms trade deals with countries, such as Saudi Arabia and Bahrain, that have poor human rights records. The previous coalition government approved arms sales to Saudi Arabia worth £4 billion, which included Tornado and Typhoon jets that have been used in air strikes against Yemen. Saudi Arabia will increase its defence budget by approximately 27% over the next five years - making it a lucrative market for the UK defence export industry. The defence industry must ensure that a balance is met between industry development and acting on behalf of the British public, otherwise the government, MoD, and other defence operators may come under increasing scrutiny. This could do more harm than good to the industry in terms of other nations acquiring equipment and services expertise from the UK.

What we think
The UK is home to one of the most rationalised defence equipment sectors in the world and offers the latest technology at cost-effective prices. This puts manufacturers in a strong position to collaborate with international partners and remain an influencing part of the global market. However, the performance of the industry remains partly dependent upon the success of the government and MoD in securing export orders for defence equipment. Companies are developing new, in-demand technologies to exploit current market opportunities; offering their services to international markets and by entering civilian markets. The next SDSR, expected in November 2015, will largely determine the foreseeable future development of the industry. The government’s commitment to meeting NATO’s 2% spending commitment until 2020 should ensure that a similar outcome to the last SDSR will not impact the sector as severely.